Chapter 9 - Business Cycles,
Unemployment, Inflation

This chapter provides an introductory look at the macroeconomic
problems of unemployment and inflation. We will study economic growth
in greater detail in two weeks when we study chapters 8 and 22
Web.

1. A peak is when business activity reaches a temporary
maximum, unemployment is low, inflation high.

2. A recession is a decline in total output, unemployment rises
and inflation falls.

3. The trough is the bottom of the recession period,
unemployment is at its highest, inflation is low.

4. expansion (recovery) is when output is increasing,
unemployment begins to fall and later inflation begins to
rise.

Unemployment increases during business cycle recessions and
decreases during business cycle expansions (recoveries). Inflation
decreases during recessions and increases during expansions
(recoveries).

Review: Maximizing Satisfaction

The primary reason to study unemployment is that it contributes to
scarcity. Scarcity always exists since resources are limited and
human wants are unlimited. There are five ways to reduce scarcity -
the five Es of economics (see diagram below). Full employment is one
of the five Es. We defined full employment as "using all available
resources". If a society uses ALL AVAILABLE RESOURCES then more
goods and services will be produced and scarcity will be reduced

Another way to illustrate the effects of unemployed resources is
with the production possibilities curve (see graph below). Point "D"
illustrates the effect of unemployment. Points "A", "B", and "C"
represent the maximum possible levels of production WITH FULL
EMPLOYMENT. With unemployment, less will be produced (point "D").

Finally, we have illustrated unemployment before using the AS-AD
model.

If the equilibrium level of output is less than the full
employment level as illustrated on the graph above, this indicates
that some available resources are unemployed and less is being
produced.

What is unemployment?

The unemployment rate in the United States was 4.5% in February,
2007 and 9.8% in September, 2009. Whenever we see a "%" we have to
ask "percent of what?" In February of 2007 4.5% of what was
unemployed?

Many people think that the unemployment rate is a measure
of who is receiving an unemployment insurance check, in
fact, it includes many more people than that.

Because unemployment insurance records relate only to
persons who have applied for such benefits, and since it is
impractical to actually count every unemployed person each
month, the Government conducts a monthly sample survey
called the Current Population Survey (CPS) to measure the
extent of unemployment in the country. The CPS has been
conducted in the United States every month since 1940 when
it began as a Work Projects Administration project. It has
been expanded and modified several times since then. As
explained later, the CPS estimates, beginning in 1994,
reflect the results of a major redesign of the survey.

Who is counted as employed?

Not all of the wide range of job situations in the
American economy fit neatly into a given category. For
example, people are considered employed if they did any
work at all for pay or profit during the survey week.
This includes all part-time and temporary work, as well
as regular full-time year-round employment. Persons also
are counted as employed if they have a job at which they
did not work during the survey week because they
were:

On vacation;

Ill;

Experiencing childcare problems;

Taking care of some other family or personal
obligation;

On maternity or paternity leave;

Involved in an industrial dispute; or

Prevented from working by bad weather

Basically anyone who works at least one hour a week
for pay is EMPLOYED.

Who is not in the labor
force?

All members of the civilian noninstitutional
population are eligible for inclusion in the labor force,
and those 16 and over who have a job or are actively
looking for one are classified as in the labor force.

All others--those who have no job and are not looking
for one--are counted as "not in the labor force."

Many who do not participate in the labor force are
going to school or are retired. Family responsibilities
keep others out of the labor force. Still others have a
physical or mental disability which prevents them from
participating in labor force activities.

Those not in the labor force then includes:

students who are not working and not looking for a
job

homemakers

people who are institutionalized

retired people who are not working and not
looking

people who may be working but illegally (e.g. drug
dealers)

discouraged workers - people who may have had a
job and were employed, they lost their jobs and looked
for another and were then unemployed, and then they
gave up looking so now they are not in the labor force
anymore.

All persons who were not classified as employed during the
survey reference week, made specific active efforts to find a job
during the prior 4 weeks, and were available for work.

All persons who were not working and were waiting to be called
back to a job from which they had been temporarily laid off.

Two factors cause the official unemployment rate to understate
actual unemployment.

Part time workers are counted as "employed."

"Discouraged workers" who want a job, but are no longer
actively seeking one, are not counted as being in the labor force,
so they are not part of unemployment statistic.

Calculating the Unemployment Rate

The unemployment rate is defined as the percentage of the labor
force that is not employed. Note that it is NOT the percentage of the
POPULATION.

To calculate the unemployment rate:

UE rate = (# unemployed / labor force) x 100

So using the data for 2007 above:

the labor force = 153.1 million people

those unemployed = 7.1 million people

So the unemployment rate was:

(7.1 / 153.1) x 100 = 4.6 % of the labor force.

What Is "Full Employment"?

Full employment equals between 4 and 5 % unemployment !!!

As we discussed above, full employment results in reducing
scarcity by producing the economy's potential level of output. The
unemployment rate in 2007 was 4.5%, that amounts to about 71 million
people unemployed. Remember that unemployed means not working but
looking. So with 7.1 million people unemployed we still have FULL
EMPLOYMENT!!

How can 4% to 5% unemployment be considered full employment?

How can 7.1 million people looking for work be called "full
employment?

It depends on how we define full employment. We have defined full
employment as using all available resources so as to achieve the
potential level of output for an economy. Full employment is
achieving the potential level of output. So, with some types of
unemployment an economy can still produce its potential level of
output.

Full employment means achieving the potential
output

As we learned in our AS-AD lesson "potential output" is
NOT the absolute maximum, but it is the potential level of output
under normal circumstances

Graphically, the potential, or the full employment output can
be illustrated three ways:

1) Points A, B, and C on the production possibilities
curve represent a full employment of resources.

2) Equilibrium on the short run AD - AS graph below is at
the full employment level of output.

3) potential output is the level of output on the long run
aggregate supply curve.

Economists estimate that about 4 %to 5% unemployment is Full
Employment. This is called the "full employment rate of
unemployment", or the "natural rate of unemployment" and it includes
structural and frictional unemployment

What? To understand how and economy with 4-5% unemployment can be
achieving the potential level of output and therefore have "full"
employment" , we must understand the three different types, or
causes, of unemployment.

Types of Unemployment

To understand how we can achieve the potential level of output and
still have 4.5 % unemployment we must understand the three types, or
causes, of unemployment. The key to understanding what full
employment means, is to consider what happens to output with
each type of unemployment.

1. Frictional Unemployment

WHAT IS
FRICTIONAL UNEMPLOYMENT?

Frictional
unemployment is the type of unemployment caused by workers
looking for their first job, voluntarily changing jobs, and
by temporary layoffs. It is unemployed workers between jobs.
Frictional unemployment is "good" unemployment
because without it the economy could not be producing as
much as possible (i.e. achieving the potential level of
output).

HOW DOES
FRICTIONAL UNEMPLOYMENT AFFECT SCARCITY?

How can the economy be achieving the potential
level of output if some people are frictionally unemployed?
First, frictional unemployment is NECESSARY in order for the
economy is to achieve its potential level of output. For
example, let's assume an engineering student has just
graduated from college and is looking for a job. He/she is
frictionally unemployed. Would society's scarcity be reduced
as much as possible if that engineer takes the first job
he/she finds? On the way home from graduation he/she sees a
"HELP WANTED" sign, turns in, applies, and works the rest of
his/her life at McDonald's. Is this good for society? OR
would it be better for society if they NOT take that job at
McDonald's and remain frictionally unemployed longer? We
need some frictional unemployment to get resources to the
jobs where they produce the most so some frictional
unemployment actually reduces scarcity. To produce as
much as possible with our limited resources we need some
frictional unemployment.

WHAT CAN THE
GOVERNMENT DO TO REDUCE FRICTIONAL UNEMPLOYMENT?

Frictional unemployment tends to be short-lived,
BUT we do not want it to last too long. If that engineer is
unemployed for many years looking for just the right job,
then there would be more scarcity than if he/she had taken
the job at McDonald's. Therefore programs to keep it low
would help reduce scarcity and governments have such
programs like state employment offices and career placement
offices at universities. These programs help people find
jobs quicker so that more can be produced.

2. Structural Unemployment

WHAT IS
STRUCTURAL UNEMPLOYMENT?

Structural
unemployment is unemployment of workers whose skills are not
demanded by employers. They are unemployed because they lack
sufficient skill to obtain employment, or they cannot easily
move to locations where jobs are available.

Structural unemployment can result from changes in the
structure of demand for labor; e.g., when certain skills
become obsolete or geographic distribution of jobs
changes.

HOW DOES
STRUCTURAL UNEMPLOYMENT AFFECT SCARCITY?

Structural unemployment results from people not
having the necessary skills. If these people are
unemployed, what happens to scarcity? Nothing! Nothing
happens to scarcity is they are unemployed because they
don't have the skills needed to produce anything. Therefore
we can still produce our potential level of output with our
available resources even if there is structural
unemployment. If resources without skills were put to work,
they, by definition, couldn't produce anything because they
don't have the skills.

WHAT CAN THE
GOVERNMENT DO TO REDUCE STRUCTURAL UNEMPLOYMENT?

But, do we want these workers to just do nothing?
NO. We studied in the 5Es lesson that more workers or better
workers results in economic growth. Economic growth is
increasing out potential level of output. This is good for
society since it also reduces scarcity. Therefore
governments have economic growth programs to reduce
structural unemployment like financial aid for school and
job training programs.

3. Cyclical Unemployment

WHAT IS
CYCLICAL UNEMPLOYMENT?

Cyclical
unemployment is a type of unemployment caused by
insufficient total spending (or by insufficient aggregate
demand). It is unemployment caused by the recession
phase of the business cycle. If there is less aggregate
demand firms respond by producing less. Output and
employment are reduced. The extreme unemployment during the
Great Depression (25 percent in 1933) was cyclical
unemployment.

HOW DOES
CYCLICAL UNEMPLOYMENT AFFECT SCARCITY?

If there is a recession and therefore an increase
in unemployment associated with a decrease in output,
this results in more scarcity. This is not good for
society since it will be producing at a point inside its
production possibilities curve (point D on the graph below)
or at a level of output short of the full employment level.

WHAT CAN THE
GOVERNMENT DO TO REDUCE CYCLICAL UNEMPLOYMENT?

Therefore, governments have policies to reduce
cyclical unemployment. These are the demand management
policies discussed in our lesson on the AS-AD. Expansionary
fiscal policies (increasing government spending or
decreasing taxes) and easy money policies (increasing the
money supply) are designed to increase AD, reduce cyclical
unemployment, and and move the economy back to the full
employment level of output. .

It is sometimes not clear which type of unemployment describes a
person's unemployment circumstances.

So to repeat: economists estimate that about 4 %to 5% is Full
Employment. This is called the "full employment rate of
unemployment", or the "natural rate of unemployment" and it
includes:

the frictional unemployment and

the structural unemployment,

but NO cyclical unemployment. In other words, full employment
is zero cyclical unemployment.

If there is some frictional and structural unemployment in the
economy can the potential level of output still be achieved? YES, and
economists estimate that there is between 4% and 5% frictional and
structural unemployment in the US economy. that is why we are
currently at, or below, full employment.

The "full employment rate of unemployment" is
the unemployment rate occurring when there is no cyclical
unemployment and the economy is achieving its potential
output

Changes in the Full Employment (Natural) Rate of
Unemployment

The natural rate of unemployment is not fixed but depends on the
demographic makeup of the labor force and the laws and customs of the
nations. in the United States in the 1060s the full employment rate
of unemployment was around 4%. this was the target of President
Kennedy's tax cut program In the 1970s the full employment rate of
unemployment was around 5%. and it was about 6% in the 1980s.

Why did the full employment rate of unemployment increase? Or,
another way of saying this is "why did the amount of frictional and
structural unemployment increase?" There were several cultural and
demographic changes during these decades that resulted in more
frictional and structural unemployment. After World War II ended in
the 1940s the baby boom began. By the 1960s this large increase in
population was beginning to enter the labor force. As they begin
looking for their first jobs they were frictionally unemployed. Also
during these decades the roles of women were changing and more women
entered the labor force for the first time (frictional unemployment)
and many did not have the necessary skills (structural
unemployment).

Recently the natural rate has dropped from 6% to 4 to 5%. This is
attributed to (1) the aging of the work force with fewer new entrants
reducing frictional unemployment, (2) improved job information
through the internet and temporary-help agencies which also reduces
frictional unemployment, (3) new work requirements passed by congress
with the most recent welfare reform which encourage those who are
frictionally unemployed to try to get a job quicker, and finally, (4)
the doubling of the US prison population since 1985 has removed from
the labor force a group of people who have a high rate of
unemployment.

As we have discussed many times, the problem with unemployed
resources is that they could have been used to produce more boats - -
or cars or whatever it is that society wants. With unemployment there
is more SCARCITY. This loss of goods that could have been produced if
we had used all of our resources is called the GDP gap and it is a
measure of the cost of unemployment.

The GDP gap = actual GDP - potential GDP

GDP gap: The
amount by which actual gross domestic product falls below potential
gross domestic product. GDP stand for Gross Domestic Product. We will
study how to measure GDP in chapter 6 next week. For now, GDP is a
measure of how much is produced in an economy in a year.

If the GDP gap is
negative then the potential GDP > the actual GDP and economy is
not producing as much as possible. This is how much more output could
have been produced if there was full employment. The GDP gap then is
the lost output caused by not having full employment.

If the GDP gap is
positive then the actual GDP is > the potential GDP. It is
possible to have a positive GDP gap if AD is very high and it crosses
the AS curve in the classical range BEYOND the full employment level
of real domestic output. The result is high inflation.

One way to measure this cost is with Okun's Law. Economist Arthur
Okun quantified the relationship between unemployment and GDP as
follows: For every 1 percent of unemployment above the natural rate,
a negative GDP gap of about 2 percent occurs. This is known as
"Okun's law." What this means is for every one percentage point
decrease in the unemployment rate output increases about 2%. The
larger increase in output is due to more people (discouraged workers)
reentering the labor force. So a 1% decrease in unemployment really
means that there are more than 1% more people working.

Non Economic Costs

There are also many non-economic costs associated with inflation.
These costs include:

Unequal burdens of unemployment exist.

Rates are lower for white collar workers.

Teenagers have the highest rates.

African-Americans have higher rates than whites.

Rates for males and females are comparable, though females had
a lower rate in 2002.

Less educated workers, on average, have higher unemployment
rates than workers with more education.

"Long term" (15 weeks or more) unemployment rate is much lower
than the overall rate, although it has nearly doubled from 1.1% in
1999 to 2% in 2002.

Noneconomic costs include loss of self respect and social and
political unrest.

What is Inflation?

In January of 2007 the inflation rate was 2.1 %. But what does
this mean? 2.1% of what? An inflation rate of 2.1% in January of 2007
means that the price level was 2.1% higher than it was in January of
2006. In the chapter on aggregate supply and aggregate demand we
learned that the price level is "the average level of prices in the
economy". We find the price level on the vertical axis of the AS-AD
graph.

But how is the price level measured? What numbers would one put
along the vertical axis? How can we measure the average level of
prices in an economy? To do this economists use a "price index". In
order to calculate inflation we need to know how the price level is
measured, therefore we need to learn about a price index.

Measuring Inflation: Price index

Our textbook defines a price index
in an index number which shows how the weighted average price of a
market basket of goods changes over time. What does
that mean? There are two price indices that we will use
this semester. We will study the GDP Price Index in the chapter on
measuring GDP (or real domestic output - RDO). To learn how to
measure inflation we will use the CPI, the consumer price index.

The CPI is an index which
measures the prices of a fixed market basket
of over 200 categories of goods and services bought by a
typical consumer in.

It works this way:

A list of over 200 items bought
by the typical consumer is drawn up. The list is then
"weighted" meaning that they do not include 1 car, 1,
computer, 1 house, 1 pizza, one gallon of gasoline, etc.
Instead they "weight" each item according to its share in
the typical consumer's budget. Each month data collectors
collect prices of each item in the "market basket" and an
average price is calculated. The price of the market
basket each month is compare to its price in a "base
year". So the
numbers in the CPI
tell
us the value of the market basket each year AS A PERCENT
OF ITS VALUE IN A BASE YEAR
The years 1982-1984 have
been selected as "base year" and assigned the index
number of 100 (see table at right)..

So, in 1988 the CPI was 118.3
which means that the price of the market basket in 1988
was 118.3% of what it was in the base year. Or the price
was 18.3 % higher than in the base year.

Each month, BLS data collectors called
economic assistants visit or call thousands
of retail stores, service establishments,
rental units, and doctors' offices, all over
the United States to obtain information on
the prices of the thousands of items used to
track and measure price changes in the CPI.
These economic assistants record the prices
of about 80,000 items each month representing
a scientifically selected sample of the
prices paid by consumers for the goods and
services purchased.

During each call or visit, the economic
assistant collects price data on a specific
good or service that was precisely defined
during an earlier visit. If the selected item
is available, the economic assistant records
its price. If the selected item is no longer
available, or if there have been changes in
the quality or quantity (for example, eggs
sold in packages of 8 when they previously
had been sold by the dozen) of the good or
service since the last time prices had been
collected, the economic assistant selects a
new item or records the quality change in the
current item.

The recorded information is sent to the
national office of BLS where commodity
specialists who have detailed knowledge about
the particular goods or services priced
review the data. These specialists check the
data for accuracy and consistency and make
any necessary corrections or adjustments
which can range from an adjustment for a
change in the size or quantity of a packaged
item to more complex adjustments based upon
statistical analysis of the value of an
item's features or quality. Thus, the
commodity specialists strive to prevent
changes in the quality of items from
affecting the CPI's measurement of price
change.

Year

CPI

1976

56.9

1977

60.6

1978

65.2

1979

72.6

1980

82.4

1981

90.9

1982

96.5

1983

99.6

1984

103.9

1985

107.6

1986

109.6

1987

113.6

1988

118.3

1989

124.0

1990

130.7

1991

136.2

1992

140.3

1993

144.5

1994

148.2

1995

152.4

1996

156.9

1997

160.5

1998

163.0

1999

166.6

2000

172.2

2001

177.1

2002

179.9

2003

184.0

2004

189.9

2005

195.3

2006

201.6

2007

207.3

2008

215.3

READ THE FOLLOWING THEN CLICK ON THE LINK BELOW
AND LISTEN TO THE 5 MINUTE RADIO REPORT ON THE
CPI

All Things Considered, July 19, 2006 · The
Bureau of Labor Statistics today released the monthly
Consumer Price Index, a key economic indicator that
tracks inflation. To track prices, the Labor
Department sends out hundreds of people around the
country to monitor prices for everything Americans buy
-- from tires to food and college tuition.

Robert Siegel went shopping with Caren Gaffney to
find out how the Consumer Price Index is compiled. On
the outing, Gaffney, a former telecommunications
executive, checked prices in two grocery stores in the
Washington, D.C., area. Siegel discusses the index
with economists Mark Zandy of Moody's Economy.com, the
Cleveland Federal Reserve's Michael Bryan and the
University of Rochester's Mark Bils.

Since a price index measures the price level as a percent of a
base year and inflation measures the change in the price index
from the previous year, to calculate the inflation rate we use
the following formula:

This calculator uses the Consumer Price Index
(1982-84=100) and the following simple formula to convert
dollar amounts between two different years.

Converted$ = (StartYear$ / StartYearCPI) *
ConvertYearCPI

Any time you compare dollar amounts over time, the
amounts should be adjusted for price inflation. With this
calculator, you can compare the real buying power of any
dollar amount you enter in the box. For example, $100 in
1913 had the same buying power as $1,584.85 in 1996.

There is not demand pull inflation every time AD increases.
If AD crosses AS in the Keynesian range of the AS curve (AD1
and AD@ in the graph below) then an increase in AD will not
cause an increase in the price level and there will be no
inflation. If AD increases in the intermediate range or the
Classical range the result will be a rising price level and
inflation.

Cost-push (or supply-side) inflation

Cost-push or supply-side inflation
caused by reductions in aggregate supply. The main causes of
cost-push inflation are (1) "wage-push" as result of union
strength and (2) supply shocks that may occur with unexpected
increases in the price of raw materials.

Effects of Inflation

There are two major effects of inflation.
"Redistributive effects" means that inflation affects different
groups differently. Some people are hurt by inflation and some people
are helped by inflation. The "output effects" of inflation include
its impact on how much is produced in an economy.

Redistributive effects of inflation:

Fixed-income groups will be hurt by inflation
because their real income suffers. Their nominal income (the size
of their paychecks) does not rise with prices, but if their is
inflation the purchasing power of their paycheck, or their real
income, would decrease.

Note "flexible income receivers" like
those who receive social security payments avoid being hurt by
inflation. Social security payments are not fixed since they
have a cost-of-living-adjustment or COLA. This is an automatic
increase in the incomes when inflation occurs. Some union
contracts also have COLA clauses.

Savers will be hurt by unanticipated inflation, because
interest rate returns may not cover the cost of inflation. Their
savings will lose purchasing power.

Debtors (borrowers) can be helped by unanticipated
inflation. Interest payments may be less than the inflation rate,
so borrowers receive "dear" money and are paying back "cheap"
dollars that have less purchasing power for the lender.

Creditors (lenders) are hurt by unanticipated inflation
since they will charge an interest rate that is "too low" since
they did not expect to be paid back with dollars that are less
valuable.

If inflation is anticipated, the effects of inflation
may be less severe, since wage and pension contracts may have
inflation clauses built in, and interest rates will be high enough
to cover the cost of inflation to savers and lenders.

"Inflation premium" is amount that interest rate
is raised to cover effects of anticipated inflation.